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A Quick 529 Tax Tip That Could Save You Big Money

Many states allow account holders to withdraw contributions shortly after making them, meaning you could get a tax break for adding money you plan to spend on college this fall. 

Adam Zoll, 07/30/2013

Question: My son will be entering college in the fall, and I own a 529 college-savings account in his name. Rather than pay tuition directly to the school, can I add the money to the 529 so I can claim the state tax deduction and then withdraw it to pay tuition?

Answer: At first blush your idea might strike some readers as far-fetched. Surely states wouldn't give someone a tax break just for putting money into a 529 account for a few days, right? But the surprising answer is that many states do allow this, imposing no waiting period on 529 withdrawals and allowing account holders to deduct contributions from their state income taxes regardless of how long the money is held in the account. For families with near-term college expenses, this 529 tax loophole can be a relatively easy way to lower their state income tax bill in the process of paying tuition, room and board, and other college-related costs.

The idea is rather straightforward. Let's say a family with a child attending school in the fall plans to pay all or a portion of tuition out of pocket. Rather than paying the school directly, the family instead adds the funds to an existing or newly opened 529 account in the student's name and then withdraws them shortly thereafter to cover the tuition payment. This allows the family to deduct the amount of the contribution from their state income taxes, assuming their state offers a tax break on 529 contributions, they haven't already maxed out their 529 deduction limit for the year, and their plan has no waiting limit for withdrawals.

The higher the state income tax rate and the higher its 529 tax-deduction limit, the more this strategy is likely to pay off. For example, Illinois allows residents to deduct up to $20,000 per year in contributions to its 529 plans (for a couple filing jointly, or $10,000 for an individual) and has a flat income tax rate of 5%. If a family contributed $20,000 to one of the state's 529 plans and then withdrew the money for tuition this fall, it would gain a tax break of $1,000 ($20,000 x .05).

First, Know the Rules 
But before embarking on this strategy it is important to remember a few key considerations. First, it's important to check with the 529 plan to find out what its rules are regarding when contributions may be withdrawn. Plans may impose a waiting period of a few days or weeks before withdrawals may be made to ensure that the contributed funds have cleared.

The decision as to whether to allow tax breaks for 529 contributions that are withdrawn after only a short time in the account varies from state to state, but most states do not impose a waiting period, according to FinAid.org, a college-savings website. Some states impose a one-year waiting period before 529 contributions may be withdrawn or limit the tax deduction to the amount of contributions minus withdrawals.

For residents of the 34 states that offer state income tax breaks for contributing to a 529 plan (usually for in-state plans only), this loophole could amount to tax savings of hundreds or even thousands of dollars.

Keep in Mind Federal Tax Breaks, Other Considerations
Once you've confirmed that your state does not impose a waiting period before withdrawing 529 contributions, and that you are eligible for a state income tax break on contributions, there are a few more details to keep in mind.

Adam Zoll is an assistant site editor with Morningstar.com


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